Italy Votes for Chaos and the Euro Crisis Is Back

Feb. 26 (Bloomberg) -- Italy’s parliamentary election could
not have gone worse for the country or the euro area.

It is now possible that in the coming months the currency
zone’s third-largest economy will need a bailout from
international creditors, at a time when Italy will have no
government in place to ask for, or negotiate, a rescue. In case
you had any doubts, the euro-area crisis is back.

As has so often been the case in Italy, the political
gridlock has come in the Senate. Neither Pier Luigi Bersani’s
center-left coalition, nor the center-right led by Silvio
Berlusconi managed to win a majority, in a political system
where a government needs the support of both houses in order to
get anything done.

Even more worrisome, Beppe Grillo’s Five Star Movement,
which has called for a referendum on whether Italy should keep
the euro, has emerged as a major political force with a quarter
of the vote.

Most observers had expected a partnership between Bersani’s
Democratic Party -- which scraped a win in the lower house --
and Prime Minister Mario Monti’s centrists to get a majority in
the Senate. But Monti scored just 10.6 percent of the vote,
while Berlusconi and Grillo did better than expected in regions
that are key to winning the Senate.

Long Road

Italy now has a long road to travel before it can put
together a government able to pursue the painful changes to the
economy that the markets and the European Central Bank demand.
Financial markets hadn’t priced in such an inconclusive result,
and the selloff of Italian assets that it triggered this week
will probably continue, pushing up the country’s borrowing
costs.

The bottom line is that Italy will almost certainly have to
hold a second election; the only real question is when. In the
meantime, there are four central scenarios for attempts to form
a government.

The first would be for Bersani and Monti to create a
minority coalition in the Senate, with Berlusconi offering his
support in exchange for certain measures to be passed. This kind
of horse trading would be unstable, and we could expect
Berlusconi to withdraw his backing at the first hint that he
wasn’t getting his way. “Il Cavaliere” (the Knight), as
Berlusconi is known, has a long track record -- it was he who
forced early elections.

A second possibility is that the center-left and center-right could form a grand coalition. The difficulty here is that
Berlusconi’s and Bersani’s partner on the left, Left Ecology
Freedom party leader Nichi Vendola, has already ruled this out.
The third option is a coalition between Berlusconi and Grillo in
the Senate, the least likely outcome of all, given Grillo’s
disdain for his fellow comedian.

The final possibility is for Grillo to join forces with
Bersani and Monti. The Five Star Movement leader has insisted
throughout the election campaign that he would not partner with
other parties, and may stick to this line to maintain his anti-establishment credentials. Even if Grillo changes his mind, it
seems unlikely that he will sit quietly on the sidelines while
Bersani and Monti pursue a policy of structural reform and
austerity. So this arrangement would also be unstable.

Quick Collapse

What all of these potential governments have in common is
that it would be politically impossible for them to implement
the kinds of changes to Italy’s spending, labor and product
markets that the bond markets, the ECB and potential creditors,
such as Germany and the International Monetary Fund, would want
to see. We could expect any of these arrangements to collapse
quickly.

Nevertheless, a parliament will have to be formed, because
in Italy, the president of the republic holds the power to call
a vote, and President Giorgio Napolitano is near the end of his
term. So before new elections can be held, parliament must
choose a new president to call them.

The new parliament will probably also want to pass an
electoral law, which should be reasonably easy to do, if the
center-left, the centrists and Grillo can form a temporary
coalition. All three groups are in favor of reducing the number
of provinces and members of parliament, as a way of lowering the
cost of politics. Any other political permutation would see
protracted wrangling over an electoral law.

Electing a president, passing an electoral law, holding a
new election and forming a new government will take time. In the
interim, investors will be concerned that Italy may be unable to
repay its loans. Italy has the world’s third-largest debt pile,
at $2.16 trillion and 126 percent of gross domestic product,
with 273 billion euros ($356 billion) due for repayment this
year. Voters not only failed to bring to power a government that
can implement the reforms necessary to stabilize Italy’s
mountain of debt, but roughly half of them cast a ballot for
anti-austerity parties (Berlusconi’s center-right coalition and
Grillo’s Five Star Movement). Italy clearly suffers from an
advanced case of austerity fatigue.

Worst of all, the country could be shut out of debt markets
at a time when it cannot make use of the support mechanisms that
exist for such an occasion. If investors decide that buying
Italian debt is not worth the risk and Italy loses market
access, the government could normally request support from the
European Stability Mechanism -- the European Union’s bailout
fund --and the ECB’s Outright Monetary Transactions bond-buying
program.

No Access

In order to use these mechanisms, the Italian government
would have to agree to a series of structural reforms and fiscal
targets that are stricter than those the country has been
pursuing. If the government in place cannot make progress on the
latter, it can’t credibly sign up to the former. No
conditionality means no access to Europe’s bailout fund and no
ECB bond purchases. Without access to the markets or to these
support mechanisms, Italy could face a default.

The euro area has shown itself adept at crafting last-minute solutions when pushed to the brink, so that could happen
again. But, by nature, this will be an extremely unsettling time
for a currency area whose collective economy is already under
severe strain.

These are significant risks before a second ballot takes
place. There is also a chance that a second election might
deliver a majority to Berlusconi or -- even worse -- to Grillo.
It is too early to guess what the results of a second election
might be, or who would even run in them. What is clear is that
Italy and the euro area are in for some rough months ahead.

(Megan Greene is a Bloomberg View columnist and chief
economist at Maverick Intelligence. She is also a senior fellow
at the Atlantic Council in Washington. The opinions expressed
are her own.)